Economics

No trivial matter

AMERICA’S national debt has been keeping me up nights. I don’t worry so much about the deficit we are running this year. I worry about entitlements and, so far, a lack of resolve to address them.

Megan McArdle recently explained the difference between structural and cyclical deficits. A cyclical deficit is when the government runs a deficit during a recession. That can actually be prudent fiscal policy. It cushions the pain of unemployment and stabilises the economy. It can restore positive growth faster. Larry Summers said at our Buttonwood conference that one of the lessons learned from the Great Depression was that fiscal austerity before the economy has fully healed does far more harm than good.

Structural deficits are the cause for concern. We run a structural deficit when the government’s operating budget involves spending more than it collects in revenue each year, even during boom times. That means the deficit grows in excess of its interest payments. That is not necessarily a problem so long as economic growth is large enough that the government can continue to service the debt. So far that has been the case, but not for long.

Medicare already pays out more than it takes in as tax revenue. It currently is drawing on the assets of its "trust fund" (its stock of government securities, so spending it arguably already adds to national debt) and these assets will be depleted by 2017. After that, unless there is a tax increase or major reform, Medicare spending will be financed by debt. The Trustees Report estimates that by 2018 only 81% of Medicare expenditure will be financed by tax income and this will fall to just 50% by 2050.

In 2018 Social Security will start to run a deficit and draw on its "trust fund". By 2039 it will also be out of cash. This means, short of major reform, entitlements will add a significant amount to our structural deficit in the not-too-distant future. Megan McArdle claims the structural deficit is projected to be 6% of GDP by 2020. The debt burden will only grow further as the population ages and more people collect benefits while fewer pay taxes. Medicare, Medicaid and Social Security are projected to cost 18% of GDP by 2050. America must expect Chinese levels of economic growth if it does not plan on serious entitlement reform.

According to the last Trustees Report the Social Security shortfall (the amount that payout exceed tax revenue) alone is projected to be about 1.2% of projected GDP from 2040 onward. Earlier this year I had lunch with Brad Setser, a former blogger at the Council on Foreign Relations. He tried to convince my colleague and me that this was such a trivial number we need not worry about reforming Social Security. In a post he wrote a few years ago he explained his reasoning, citing CBO projections:

True, projections show a deficit of something like 1.5% of US GDP in Social Security starting around 2045. See Figure 1-3 in the CBO’s outlook. That of course assumes the US treasury doesn’t default on its obligations to the Social Security trust fund.

However, I don’t get why a 1.5% of GDP deficit after 2045 is a bigger problem than the current 3.5% of GDP gap (per the CBO—see the on-budget deficit in 2006 on p. 22) between the revenues of the government (excluding social security) and its current spending (excluding social security). The current on-budget deficit came even with more revenues from the tax on corporate profits than at any time since the 1970s. That may not last (even if the stock markets seems to think it will).

Deficits in the non-Social Security part of the government now, usually financed by borrowing from the central banks of non-democratic countries v. smaller deficits in Social Security after 2045. Which is the bigger problem?

First of all 1.5% of GDP is not a trivial amount of money. Also, a reason why paying for Social Security each year with debt is a problem is that it is autonomous spending. It commits the government to running a sizable deficit each year into perpetuity.

Much of the spending that makes up the 3.5% Mr Setser cites is from discretionary or defense spending. Each of these factors can change year to year (hopefully we will not be financing a war indefinitely). Spending on things like farm subsidies can and should be reduced (or handed off to the states). Committing to a large structural deficit indefinitely can be catastrophic.It drives up the rate of interest the government pays, increasing service payments further. That makes the problem worse. The growing stock of debt also can diminish growth rates because it dampens business confidence as higher tax rates become certain. It also undermines the government’s ability to run larger deficits when it needs to deal with future recessions.

The reason to care about entitlements now is the sooner we address them, the cheaper it will be to solve the problem. Maybe 1.5% of GDP does not sound like much to Mr Setser, but America does not have the luxury to let it slide. Medicare may be a bigger problem, but that's not an excuse to ignore Social Security, especially when it can be fixed. We can increase the retirement age, raise taxes, or cut benefits in a progressive manner. The sooner reform is undertaken the less painful it will be. Cutting discretionary spending in the near future, during what will probably be an anaemic recovery, will be hard. Dealing with entitlements now gives the American government an opportunity to send markets a signal it's committed to fiscal responsibility, without impinging on recovery.

Mr Setser has since taken leave of the blogesphere to join the National Economic Council and influence the administration's economic policy. Hopefully he will not be lending his considerable public-finance expertise to any debt-reduction strategy.

Readers' comments

Perhaps many Americans (having, after all, paid in to social security for all of their lives, whether or not that money has actually just gone into a hole) simply choose to be "skeptical" of a threat from entitlement-driven government debt.

"Just wait long enough and someone will eventually come up with e-mails 'proving' that the whole thing was phoney" seems like just the kind of solution our country is ready to embrace, in these times.

Medicare is tricky to reform. What frustrates me about the social security reform is that it only seems difficult politically. A lot of people now work just fine into their 70s and I suspect most people who retire by 65 are wealthy, not poor. The last time the topic came up, it seemed that just adjusting the age at which people qualify to reflect changes in the length of folks' work lives would just about do the trick.

I'm not sure why there's so much concentration on military spending in these comments; military spending in the US has been trending down for decades (largely because when Reagan accelerated defense spending, the Soviets threw in the towel, allowing us to reduce spending.) Is there any other category of government spending that has trended down over the years? Education? Farmer welfare? Medicare? Medicaid? Transportation? Why aren't these the focus?

It all depends of which fixed interest rate, which fixed population growth rate, which GDP or productivity growth and a 4th factor that I forget.

Will we see 70 year olds working on the auto assembly lines, or are they exempt? They did get a taxpayer bailout.

Will 70 year old be fighting future wars, or are soldiers exempt?

Will state and local employees be forced to work until 70, or are they exempt?

Will (fill in your own special group)....

Funny how the old adage of "If you repeat a lie long enough, people will believe it".

But the pundits will scare people into telling Congress to raise the retirement age and cut back on benefits. We did that in the 1980's and all that occurred was the government borrowing the excess revenues over payouts, leaving Trillions of debt behind. Why should they have to pay it down?